Greed and Fear. “Risk on” and “Risk off.” “Market will do what markets will do.” It’s not unreasonable to accept that today’s markets are simply following typical patterns. There’s nothing that remarkable about the current backdrop’s wavering greed and fear – and markets taking on lives of their own. There is, however, something notably different about today’s “risk on/risk off” dynamic.
Changes in structure have altered market function, especially compared to previous crisis periods. First and foremost, the pandemic unleashed unprecedented central bank liquidity. This significantly boosted cash holdings across the system, including for financial institutions, investment managers, the leveraged speculating community, corporations and households. Spectacular asset price inflation (i.e. stocks and securities, houses, crypto, etc.) further boosted already inflated financial cushions for market operators, corporations and the household sector. For speculators large and small, an enormous pool of the “house’s money” became available for wagering and absorbing losses.
In short, the wild inflation of the world’s major central bank balance sheets significantly expanded private sector assets – from American households’ financial and real estate holdings to emerging market international reserves.
Especially after the recent market rally, talk of “resilient” has become commonplace and central to the bullish narrative. And this resilience – at home and abroad – is undoubtedly associated with the “buffer” created from Trillions of pandemic QE. The significant tightening of market financial conditions for the most part didn’t spark panic in corporate boardrooms. Household net worth took a hit from sinking stocks prices. But the extraordinary inflation in securities and home prices ensures perceived household wealth remains significantly above pre-pandemic levels. And for the vulnerable emerging markets, huge international reserve holdings made “risk off” deleveraging and “hot money” outflows more manageable.
Back to “risk on/risk off.” Central bankers across the global were raising rates. Faced with acute inflation risk, the Fed was especially hawkish. Bubbles were bursting – from Chinese developers and apartments, to global bond markets, to technology stocks and the cryptocurrencies. There was every reason to hedge risk across the markets, and players from major institutions to hedge funds to individual investors flocked to derivatives markets for protection.
When a large segment of a marketplace offloads risk to the derivatives markets, there becomes clear and present danger for “risk off” derivatives-related selling spurring illiquidity, dislocation and a market crash. The near collapse of the UK gilts market underscored how leverage and derivatives combine for a potentially lethal mix.
But current market structure also creates susceptibility to abrupt market reversals, squeezes, and the unwind of hedges sparking powerful bear market rallies. Post-pandemic QE-related resilience significantly boosts the probability of robust counter-trend market advances. Indeed, in the event of “risk off” market weakness and associated derivatives-related selling, markets will tend toward bipolar outcomes. The prospect of a derivative-related “accident” will induce additional hedging and selling, with markets pushed to the brink. But if markets avoid downside dislocation, the odds then surge for a reversal and period of upside discontinuity.
Global markets were careening toward dislocation when the Bank of England restarted QE in emergency operations to thwart bond market collapse. Global bond markets were buckling under the pressure of a concerted hawkish tightening cycle and deleveraging. Sentiment was also hurt last month by China’s disturbing national congress. What’s more, the dollar’s destabilizing melt-up was stoking global de-risking/deleveraging, with a “doom loop” dynamic of spiking yields, EM foreign reserves liquidation (for currency support operations), derivatives-related selling and only higher global yields.
Following the Bank of England’s lead, the global central bank community scaled back hawkishness. Fed officials definitely toned down their hawkish narrative. It might not yet have met the standards of a “dovish pivot” – and Chair Powell remains focused on his inflation-fighting credentials. Yet the Fed’s more balanced discussion was sufficient to assuage fears that the Fed “put” was missing in action. Indeed, markets saw crucial confirmation of the assumption that instability would bring the Fed’s tough inflation fight to a pleasingly early conclusion.
After jumping to 4.22% in the sessions immediately following Powell’s hawkish November 2nd press conference, 10-year Treasury yields closed this holiday week at 3.68%. In Europe, Italian yields traded this week to 3.64%, down from October’s 4.78% high. The reversal of short positions and hedges has surely played a major role in the global bond market rally – with declining yields integral to global “risk on.”
Let’s not neglect the impact of Chinese developments on global “risk on.” Economic fragility, record Covid infections, and an increasingly desperate Beijing have created an ideal blend of support for the global rally. On the one hand, lockdowns and the growing possibility of infections spiraling out of control have provided a meaningful lift to global bond prices (lower yields). Meanwhile, global risk markets have taken comfort from a litany of Beijing measures employed to support China’s developers and economy (see “China Watch” below). For highly speculative markets, it has flashed nirvana: visions of a disinflationary Chinese downturn dampening global inflation pressures, bond yields and hawkish central bankers, with an energized Beijing slashing the risk of a near-term Chinese accident.
With about a month to go, markets sense there’s a good shot at a decent year-end rally. And a solid December would be expected to presage a strong start to 2023. But that would not change my “countertrend” rally view. This market recovery, especially if it gets legs, is problematic.
Importantly, the factors that have supported system resilience simultaneously buttress inflation. I saw merit in the Fed’s inflation-fighting strategy of orchestrating a rapid increase in rates and attendant tightening of financial conditions. There were two major risks: aggressive tightening would break things (aka market dislocation), or market instability would compel the Fed to stand down before financial conditions tightened sufficiently to quash inflationary pressures.
There are always costs associated with the delay of appropriate central bank tightening. Not only did the Fed “print” $5 TN, it stuck with zero rates for way too long. And while the crypto and stock market manias were running wild, a furtive boom was taking hold in “private credit,” “decentralized finance,” and bank and non-bank lending more generally. Indeed, this lending boom has been fundamental to what I call “inflationary biases” percolating throughout the economy.
Even as equities and corporate bond markets tumbled, scores of lenders throughout the economy never had it so good. Rising prices boost demand for Credit card and home equity loans, while small and medium-sized businesses have never enjoyed such borrowing options. While market financial conditions tightened, lending conditions for much of the economy have remained extraordinarily loose.
Short of a hawkish Fed tightening market “accident,” the lending boom would have to run its course. Strong system Credit growth ensured resilience in spending, economic growth and price inflation. Meanwhile, there are major New Cycle dynamics underpinning both the economy and inflation. “De-globalization” and the emergent Iron Curtain have the potential to spur robust investment in domestic manufacturing capacity. Perhaps at least as important, climate change creates possibilities for virtually endless investment spending. With loose lending conditions, 10 million vacant jobs, and increasingly entrenched inflation, there have been all the makings for upside surprises in both GDP and CPI.
Previous cycle thinking still dominates in markets and at the Fed. Our central bank believes it will soon wrap up its tightening cycle, with cooperative inflation retreating back to its 2% target. Markets believe the great bull markets can get back on track as soon as the Fed pivots out of the way.
The Fed administered way too much monetary inflation for too long, moved belatedly to crush price inflation, and now appears prematurely losing its nerve. At this point, a significant recession and/or market accident would likely be required to rein in powerful inflationary forces operating throughout the economy. Otherwise, prepare for an extended tightening cycle with potential for meaningfully higher rates over the next couple years.
Frederick Schultz, Nancy Teeters, Emmett Rice, Lyle Gramley, Preston Martin and Martha Seger. Not household names. One must be a student of the Federal Reserve to recognize that these were members of the Board of Governors serving under Chairman Paul Volcker.
November 23 – Bloomberg (Craig Torres): “Federal Reserve officials concluded earlier this month that the central bank should soon moderate the pace of interest-rate increases to mitigate risks of overtightening, signaling they were leaning toward downshifting to a 50 bps hike in December. ‘A substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate,’ according to minutes from their Nov. 1-2 gathering… In addition, while Chair Jerome Powell said during his post-meeting press conference that rates will probably ultimately go higher than officials’ September forecasts indicated, Wednesday’s report gave a more nuanced take: ‘Various’ officials — a descriptor not commonly used in the minutes — had concluded that rates would ultimately peak at a higher level than previously expected.’”
The stage has been set for an intriguing December 14th FOMC meeting. Expect an increasingly divided Fed. I’ll assume that Chair Powell compromised with Lael Brainard and the dovish contingent in allowing the inclusion of dovish language in the previous meeting’s statement. But there was no compromising during his press conference.
Powell is undoubtedly concerned. His perceived dovish-leaning July press conference unleashed a market rally and loosened financial conditions. He has since remained keenly focused on maintaining the hawkish resolve necessary to ensure market alignment with the Fed’s inflation fight. And for a while, the entire committee was aligned behind Powell. But market instability – including a major spike in mortgage rates – has caused a splintering.
Rate markets are now pricing 5% peak Fed funds at the May 3rd FOMC meeting. The Treasury 2yr/10yr yield spread closed the week at negative 78 bps, the greatest inversion since Volcker was at the helm of the Fed in 1981. At a 3.68%, the key 10-year Treasury yield is now hindering the Fed’s inflation fight.
The bond rally and low market yields underpin “risk on.” After the squeeze and unwind of hedges, a speculative marketplace will undoubtedly anticipate the end of Fed tightening. Declining market yields will be viewed as confirmation of waning inflation.
But I see bond yields more as a reflection of market dynamics and accident risk. As usual, stocks have their short-term focus, while bonds still see accidents in the making – China, Japan, EM, tech, crypto, housing, Credit and so on. Stocks are currently enjoying a short-term bout of “risk on.” Meanwhile, major New Cycle developments lurk in the not too distant future.
Previous cycle thinking has the Fed, the global central bank community, and Beijing with everything under control. That they were ready to push back against crisis dynamics was all that was required to reverse markets and stoke “risk on”. But I expect New Cycle Realities to show themselves over time. Central banks and Beijing, in reality, don’t have things under control.
A major de-risking/deleveraging would force the Fed and other central banks to restart QE, with problematic decisions including how big and how to respond to market reactions. I’m not sure that bond markets will be as cooperative as they were to 2020’s series of ballooning QE announcements. Unless inflationary pressures dissipate more quickly than I expect, Powell will not haphazardly open the monetary floodgates.
And China. Markets are today content with dismal fundamentals that ensure a keenly focused and hardworking Beijing. Markets are today relaxed about the short-term – confident that Beijing has everything under control and that crisis dynamics will be held sufficiently at bay. But perhaps the U.S. Treasury market has its gaze further out on the horizon, where it sees the outlines of a “things are spiraling out of control” “Lehman moment” panic.
For now, “risk on” is working its magic. For the start of 2023, there will likely be less shorting and hedging. There will be more bullishness, with FOMO ensuring the marketplace becomes more aggressively positioned.
While most anticipate resurgent bull markets, New Cycle Realities fester. More layoffs and strikes. Additional tech and crypto bursting Bubble fallout. Deeper housing market angst. Rising delinquencies and Credit issues. Newfound caution from bankers and the slew of new (non-bank) lenders. Persistent geopolitical instability. Resilient inflation and a hawkish Powell. Meanwhile, QE-related “buffers”, which have underpinned markets and the economy over the past year, will have dissipated.
There will be fragilities coupled with extraordinary uncertainty. With everyone fixated on short-term speculative dynamics, the New Cycle is stealthily poised to disappoint. And does Powell have the resolve to attempt a Volcker-type legacy? Or might he capitulate to a group of doves that no one will have ever heard of forty years from now?
Original Post 26 November 2022
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Categories: Doug Noland